Adjusting Accounts for Financial Statements C H A P T E R 4 © 2007 McGraw-Hill Ryerson Ltd. Electronic Presentations in Microsoft® PowerPoint®

1. Describe the purpose of adjusting accounts at the end of the period. 2. Explain how the time period, matching, and revenue recognition principles affect the adjusting process. 3. Explain accrual accounting and cash basis accounting and how accrual accounting adds to the usefulness of financial statements. Learning Objectives © 2007 McGraw-Hill Ryerson Ltd.

4. Prepare and explain adjusting entries for prepaid expenses, amortization, unearned revenues, accrued expenses, and accrued revenues. 5. Explain how accounting adjustments link to financial statements. 6. Explain and prepare an adjusted trial balance. Learning Objectives © 2007 McGraw-Hill Ryerson Ltd.

7. Prepare financial statements from an adjusted trial balance. 8. Explain and prepare correcting entries. (Appendix 4A) 9. Identify and explain two alternatives in recording prepaids and unearned revenues. (Appendix 4B) Learning Objectives © 2007 McGraw-Hill Ryerson Ltd.

Analyze transactions Journalize Post Prepare statements Close Prepare post-closing trial balance Adjust Prepare unadjusted trial balance Prepare adjusted trial balance 2 1 The Accounting Cycle © 2007 McGraw-Hill Ryerson Ltd.

Financial information must be timely and accurate to be useful to decision makers.  Financial statements need to be prepared at regular intervals (periods).  Accounts need to be adjusted (updated) to ensure all revenues, expenses, assets, and liabilities are recorded. Adjusting the Accounts © 2007 McGraw-Hill Ryerson Ltd.

Adjustments are based on three generally accepted accounting principles:  Time period principle.  Revenue recognition principle.  Matching principle. GAAP and the Adjusting Process © 2007 McGraw-Hill Ryerson Ltd.

Time Period Principle Assumes that the organization’s activities can be divided into specific time periods such as:  Months  Quarters  Years Accounting Principles © 2007 McGraw-Hill Ryerson Ltd.

Revenue Recognition Principle Revenue is recorded at the time it is earned regardless of whether cash or another asset has been exchanged. Matching Principle Expenses are to be matched in the same accounting period as the revenues they helped to earn. Accounting Principles © 2007 McGraw-Hill Ryerson Ltd.

Accrual Basis  Revenues and expenses are recognized when earned or incurred regardless of when cash is received or paid.  Consistent with GAAP. Cash Basis  Revenues and expenses are recognized when cash is received or paid.  Not consistent with GAAP. Cash vs. Accrual Basis © 2007 McGraw-Hill Ryerson Ltd.

Types:  Prepaid expenses  Amortization  Unearned revenues  Accrued expenses  Accrued revenues Adjustments © 2007 McGraw-Hill Ryerson Ltd.

Costs paid in cash and recorded as assets before they are used are called prepaid expenses.  These costs expire with the passage of time or through use and consumption, e.g., insurance, supplies. Prepaid Expenses © 2007 McGraw-Hill Ryerson Ltd.

Prepaid Expenses–Example On January 1, a company purchases an insurance policy that covers three months and costs $1,800.  The policy will benefit the company for three months and will be expired at the end of three months.  The cost of the policy should be spread over the time period it benefits the organization. (matching principle). $600 $1,800 JanuaryFebruaryMarch © 2007 McGraw-Hill Ryerson Ltd.

Prepaid Expenses — Example $1,800 $1,800 $1,800 $1,800 The entry to record the purchase of the insurance policy would be: Prepaid Insurance 1,800 Cash 1,800 © 2007 McGraw-Hill Ryerson Ltd.

Prepaid Expenses — Example $1,800 $1,800 $1,800 $1,800 The entry to record the expiry of the insurance for January would be: Insurance Expense 600 Prepaid Insurance 600 © 2007 McGraw-Hill Ryerson Ltd.

Prepaid Expenses — Example $1,800 $1,800 $1,800 $1,800 The entry to record the expiry of the insurance for February would be: Insurance Expense 600 Prepaid Insurance 600 © 2007 McGraw-Hill Ryerson Ltd.

Prepaid Expenses — Example $1,800 $1,800 $1,800 $1,800 The entry to record the expiry of the insurance for March would be: Insurance Expense 600 Prepaid Insurance 600 © 2007 McGraw-Hill Ryerson Ltd.

Amortization is the process of allocating the costs of assets over their useful lives.  Companies acquire capital assets such as equipment, buildings, vehicles, and patents to generate revenues.  These assets are expected to provide benefits for more than one period. Straight-Line Amortization Expense = Asset Cost - Salvage Value Useful LifeAmortization © 2007 McGraw-Hill Ryerson Ltd.

On January 1,2011, a company purchased a piece of equipment for $72,000. The equipment is expected to have a useful life of four years and have a salvage value of $8,000. Amortization - Example Straight-Line Amortization Expense = Asset Cost - Salvage Value Useful Life = $72,000 - $8,000 4 years = $16,000/year © 2007 McGraw-Hill Ryerson Ltd.

Amortization - Example The entry to record the purchase of the equipment would be: Equipment 72,000 Cash 72,000 © 2007 McGraw-Hill Ryerson Ltd.

Amortization - Example The entry to record amortization at the end of the first year would be: Amortization Expense, Equipment 16,000 Accumulated Amortization, Equipment 16,000 © 2007 McGraw-Hill Ryerson Ltd.

Amortization - Example The entry to record amortization at the end of the second year would be: Amortization Expense, Equipment 16,000 Accumulated Amortization, Equipment 16,000 © 2007 McGraw-Hill Ryerson Ltd.

Amortization - Example The entry to record amortization at the end of the third year would be: Amortization Expense, Equipment 16,000 Accumulated Amortization, Equipment 16,000 © 2007 McGraw-Hill Ryerson Ltd.

Amortization - Example The entry to record amortization at the end of the fourth year would be: Amortization Expense, Equipment 16,000 Accumulated Amortization, Equipment 16,000 © 2007 McGraw-Hill Ryerson Ltd.

Amortization - Example © 2007 McGraw-Hill Ryerson Ltd.

Cash received in advance of providing products and services.  The company has an obligation to provide goods or services.  Unearned revenues are liabilities. Unearned Revenues © 2007 McGraw-Hill Ryerson Ltd.

Unearned Revenues — Example On March 1, a company received a $12,000 payment from a customer for maintenance services to be provided over the next two months. The entry to record the receipt of cash would be: Cash 12,000 Unearned Revenue 12,000 © 2007 McGraw-Hill Ryerson Ltd.

Unearned Revenues - Example On March 31, $6,000 of this revenue had been earned. The entry to record the earned revenue would be: Unearned Revenue 6,000 Maintenance Revenue 6,000 $12,000/2months= $6,000/month © 2007 McGraw-Hill Ryerson Ltd.

Unearned Revenues - Example By April 30, another $6,000 of this unearned revenue had been earned. The entry to record the earned revenue would be: Unearned Revenue 6,000 Maintenance Revenue 6,000 $12,000/2months= $6,000/month © 2007 McGraw-Hill Ryerson Ltd.

Costs incurred in a period that are both unpaid and unrecorded.  Adjusting entries must be made to record the expense for the period and the related liability at the balance sheet date.  Examples: interest, wages, rent, taxes Accrued Expenses © 2007 McGraw-Hill Ryerson Ltd.

On December 31, $1,200 of interest has accrued on a company’s bank loan. The payment of the interest is not due until January 1. The December 31 entry to record the accrued interest would be: Interest Expense 1,200 Interest Payable 1,200 Accrued Expenses - Example © 2007 McGraw-Hill Ryerson Ltd.

In December, a company incurred $3,700 of utilities expense. The company had not received the utility bill at December 31. The December 31 entry to record the accrued utilities expense would be: Utilities Expense 3,700 Utilities Payable 3,700 Accrued Expenses - Example © 2007 McGraw-Hill Ryerson Ltd.

Revenues earned in a period that are both unrecorded and not yet received in cash.  Adjusting entries must be made to record the revenue for the period and the related asset at the balance sheet date.  Examples: fees earned, interest earned, rent earned Accrued Revenues © 2007 McGraw-Hill Ryerson Ltd.

On December 31, $16,500 of consulting fees have been earned but have not been recorded or billed to the client. The entry to record the accrued consulting fees earned would be: Accounts Receivable 16,500 Consulting Fees Earned 16,500 Accrued Revenues - Example © 2007 McGraw-Hill Ryerson Ltd.

 Adjustments are only made when financial statements are prepared.  Affect both the income statement and the balance sheet.  Do not affect cash. Adjustments & Financial Statements © 2007 McGraw-Hill Ryerson Ltd.

Q If the year-end adjusting entry to record accrued wages was not recorded, how would this affect the company’s financial statements? Would the balance sheet balance? A Wages expense-understated Net income-overstated Owner’s equity-overstated Wages payable-understated The balance sheet would balance since liabilities would be overstated and owner’s equity would be understated. Mini-Quiz © 2007 McGraw-Hill Ryerson Ltd.

Unadjusted Trial Balance  Prepared before adjustments are recorded. Adjusted Trial Balance  Used to prepare financial statements.  Prepared after adjustments are recorded and posted. Trial Balance © 2007 McGraw-Hill Ryerson Ltd.

 Adjusting entries bring the accounts up-to-date.  The adjusted trial balance is used to prepare the financial statements in the following order:  Income Statement  Statement of Owner’s Equity  Balance Sheet  Cash Flow Statement Financial Statement Preparation © 2007 McGraw-Hill Ryerson Ltd.

Q When and why are adjusting entries prepared? A They are prepared when a company wishes to issue financial statements. Adjusting entries bring the account balances up-to-date. Review © 2007 McGraw-Hill Ryerson Ltd.

Errors found before posting  Draw a line through the incorrect information.  Insert correct information above the original entry. Errors found after posting Two alternatives: 1. Prepare a single correcting entry. 2. Reverse the original entry and record the correct entry. Appendix 4A Correcting Errors © 2007 McGraw-Hill Ryerson Ltd.

A payment of $1,200 for Salaries Expense is erroneously posted to Interest Expense. The original entry was recorded as: Interest Expense 1,200 Cash 1,200 The original should have been recorded as: Salaries Expense 1,200 Cash 1,200 Correcting Errors — Example © 2007 McGraw-Hill Ryerson Ltd.

Alternative 1 -Prepare a single correcting entry. The original entry was recorded as: Interest Expense 1,200 Cash 1,200 The correcting entry would be: Salaries Expense 1,200 Interest Expense 1,200 Correcting Errors — Example © 2007 McGraw-Hill Ryerson Ltd.

Alternative 2 -Reverse the original entry and enter the correct entry. The original entry was recorded as: Interest Expense 1,200 Cash 1,200 The entry to reverse this would be: Cash 1,200 Interest Expense 1,200 The correct entry would be: Salaries Expense 1,200 Cash 1,200 Correcting Errors — Example © 2007 McGraw-Hill Ryerson Ltd.

Prepaid Expenses  Often recorded as assets when paid.  Adjusting entries transfer expired portion to expense accounts at period end. Alternative Treatment  Record as an expense when paid.  Adjusting entries transfer unused portion of prepaid from the expense to the asset account. Appendix 4B: Alternatives in Recording Prepaids and Unearned Revenues © 2007 McGraw-Hill Ryerson Ltd.

Example: On January 1, a company purchases an insurance policy that covers 3 months and costs $1,800. On January 31, $600 ($1,800 x 1/3) of the policy has expired and $1,200 ($1,800 x 2/3) remains unexpired. Appendix 4B: Alternatives in Recording Prepaids and Unearned Revenues © 2007 McGraw-Hill Ryerson Ltd.

Payment Recorded as an AssetPayment Recorded as an Expense Jan.1 Prepaid Insurance 1,800Insurance Expense 1,800 Cash 1,800 Cash 1,800 Jan.31 Insurance Expense 600 Prepaid Insurance 1,200 Prepaid Insurance 600 Insurance Expense 1,200 Prepaids- Example © 2007 McGraw-Hill Ryerson Ltd.

Unearned Revenues  Often recorded as liabilities when cash is received.  Adjusting entries transfer earned portion to revenue accounts at period end. Alternative Treatment  Record as revenues when cash is received.  Adjusting entries transfer unearned portion of the payment from the revenue account to the unearned account. Appendix 4B: Alternatives in Recording Prepaids and Unearned Revenues © 2007 McGraw-Hill Ryerson Ltd.

Alternatives in Accounting for Prepaids and Unearned Revenues-Appendix 4B Example: On March 1, a company received a $12,000 payment from a customer for maintenance services to be provided over the next two months. On March 31, $6,000 ($12,000/2) of the revenue has been earned and $6,000 ($12,000/2) remains unearned. © 2007 McGraw-Hill Ryerson Ltd.

Receipt Recorded as a Liability Receipt Recorded as a Revenue Mar.1 Cash 12,000 Cash 12,000 Unearned Revenue 12,000 Maintenance Revenue 12,000 Mar.31 Unearned Revenue 6000 Maintenance Revenue 6,000 Maintenance Revenue 6000 Unearned Revenue 6,000 Unearned Revenues- Example © 2007 McGraw-Hill Ryerson Ltd.

End of Chapter © 2007 McGraw-Hill Ryerson Ltd.